The Rise and Fall of Anonymous Bitcoins

It's the digital currency that claims to be completely anonymous, non-inflationary and more secure than Fort Knox. Its largest backer, Bitcoin Foundation, says the virtual money "cannot be manipulated by any government, bank, organization or individual."

Many have been expecting the government to crack down on the currency because it has been used for illegal activities ranging from drug purchases and money laundering to avoiding sanctions in Iran.

Instead, the U.S. government has embraced it by recognizing bitcoins as a currency and saying it would not halt their use in e-commerce. The U.S. Department of the Treasury's Financial Crimes Enforcement Network, or FinCEN, says virtual currency has the status of real money and should be regulated as such. The Bitcoin Foundation calls the FinCEN ruling a "positive first step toward regulatory acceptance."

Indeed, the March ruling led to a surge of bitcoin speculation. The value of one bitcoin leaped from $49 to $290 in a few weeks, although it has dropped back to near $100. But in another sign that it has gained credibility, a prestigious private investor, Union Square Ventures, last week said it has put $5 million into a bitcoin vendor, Coinbase, a company that will process payments in virtual currencies.

But don't expect to be spending many bitcoins soon. By embracing it, the Treasury cleverly took away one of the virtual currency's unique selling points: its anonymity. FinCEN says it will not interfere with the legitimate use of bitcoins as a means of paying for goods on the Internet. But it will regulate bitcoin use if it is simply used to send money between people.

"There is much that must be built on top of these digital currencies to make them work well enough to support real business at scale," says Fred Wilson, managing partner of Union Square Ventures.

Indeed, the Treasury embrace offers legitimacy - and all that comes with it. It means money exchanges over $10,000 must be reported to Treasury, just as they are for any transaction using real dollars.

"The loss of anonymity for bitcoin from new Treasury regulation may kill the young but booming bitcoin wave in its crib," says Sam Hamadeh, chief executive officer of PrivCo.

But the history of virtual currencies - from DigiCash to Beenz - shows that even if they don't become the almighty dollar, they can spin off valuable patents and processes that enable e-commerce. One of them, CyberCash, was a predecessor to PayPal. In his blog, Wilson says Coinbase is interested in "bitcoin and other digital currencies."

Ultimately, Bitcoin's encryption could be used in making Internet transactions simpler and more secure.

A conference sponsored by Bitcoin Foundation in San Jose, Calif., this week will explore the implications of the FinCEN ruling. "We certainly have a lot of topics around financial regulation, and that's one of them. It's a big topic," says Lindsay Holland, assistant director of the Bitcoin Foundation, which focuses on legitimate uses for the virtual currency.

What does Bitcoin have to offer if you are not engaged in criminal acts?

Forget all the hype about inflation-fighting, taking government out of the money systems, and replacing the dollar. Bitcoin Foundation is largely focused on ways it adds convenience and security to online transactions.

The most likely scenario is that bitcoins could eventually be used every day as cash in a "wallet" stored in your email account. That could empower consumers to have their own online wallets with a currency they can use anywhere instead of having to sign up and give personal details to each online retailer. It could add ease of use and eliminate some of the invasive online marketing that amounts to electronic junk mail. Such applications would be particularly helpful for smartphone users, who could avoid inputting personal details when they make purchases.

The technology for sending money safely from one person to another as easily as one sends email may prove to be the enduring piece of Bitcoin's legacy. The digital coins themselves are simple sets of random numbers. But the system of keys and wallets linked to individuals is a much more advanced technology that is authenticated by multiple users. The Bitcoin solution could potentially give consumers a currency loaded into their smartphone or computer. Bitcoins could be used anywhere businesses decide the system is safe, and as long as monetary authorities are sure it's not used illegally.